Stocks and Dividends

[adios]

I know Barrons sucks but I read it none the less because I get bored sometimes. There was an article this week about companies that don't pay dividends that should. Among the examples given were CSCO and MSFT as well as some companies that pay a miniscule dividend like HD and INTC. The article also pointed out that Warren Buffet's holding company Berkshire Hathaway hasn't ever paid a dividend in thirty years and the article implied that it never plans to. Interesting as I'm reminded of something that Michael Milken (I know but I think he had a lot of good ideas) stated back in the eighties. It was why he preferred high yielding bonds to stocks. It went something like this:

With the high yielding bonds I collect a return right away. With stocks the market more or less has to agree with me that the stock is undervalued for me to collect a return. With the high yielding bonds I never have to have the market agree with me. I can simply collect the coupon payment and cash in the bond when it's called.

Even though I've bought many stocks that didn't pay a dividend, I've always thought that at some point down the road when the company matured and growth slowed that dividends would eventually be paid. It's ok to reinvest the profits in future growth because it will lead to higher profits and thus higher dividends down the road at some point. I've always thought that this was an implicit agreement between stockholders and companies i.e. that at some point profits would be returned to the shareholders (I'm aware that there are different classes of stock for some companies which may effect payouts). Apparently this is not the case. I'm also aware of double taxation and many regard stock repurchases as a more tax efficient way of paying a dividend. Certainly that's the case if you want to reinvest the dividends. However, I don't always want to reinvest them and still the market must agree that the buybacks make a stock more attractive lets say. Anyway at some point, as a stockholder, I want my share of the free cash flow if you will. The alternative to never paying a dividend is to increase share holder value perpetually and having potential buyers be "convinced" that indeed share holder value has been increased and it's worth paying more money for the stock. Am I missing something?

[Mark Heide]

Tom,

I believe the main purpose of non-dividend paying stocks was to avoid double taxation for shareholders. Companies like CSCO and MSFT grow the value of that stock by reinvesting and acquiring. I think what the problem can be is how much more can these companies really grow? If they run out of ideas, they usually go into acquisition mode. Which I think is fine as long as management can manage the acquisition to make it profitable. But, as you can see during the "dot.com" era, management did a poor job. They would trade products and services, including capital for a share of the new business.

What I would like to see happen is for the government to create a new tax code that would not penalize shareholders for dividends if shareholders reinvested the dividends themselves, whether it be the company that paid them the dividend or another business altogether. The only way you can do this now, is with a 401K account that allows you to trade.

Good Luck

Mark "The Bear"

[CEO]

You bring up some very interesting thoughts which show that you are very interested in business. I have been a shareholder of both MSFT and BRK for nearly many years now, and do not miss my dividends one bit. To me, dividends are an admission that the company cannot find something to do with their cash to earn a suitable return in their respective business.

You are on the right track considering Warren Buffett. I suggest you read his many annual reports on the Berkshire website, and/or get a copy of a book of his writings complied by Prof Lowenstien (spelling may be wrong).

Good luck in your investing, just be careful about investment advice, since most of it is self-serving and incorrect.

As Mark and CEO attest, double taxation is a big reason why companies don't pay dividends. It is also quite true that companies like CSCO, MSFT and BRK are still trying to grow (whether or not they should think so), and so they want to reinvest profits rather than distribute them to shareholders.

On the other hand, WPO, is an example of a relatively mature operation. BRK is a major shareholder of WPO, and if it weren't for double taxation, Buffett (who is on the board) would favor paying dividends, so that, in particular, BRK could apply the cash to other ventures. Instead, until two years ago, WPO repurchased its stock rather than paying dividends. So WPO's market cap hasn't grown quite as much as its share price (you can also see Buffett's influence in WPO because they never split the stock).

One of the reasons that Buffett likes to buy companies outright is because then the profits are only taxed once, after which he is free to redistribute the cash (internal to BRK) to other BRK ventures.

Double taxation is a very serious problem for the U.S. economic and financial system. There are a number of ways it increases the risk of stock investment in publicly traded companies because of the penalty for dividend payments, and they can be seen by contrast to what you reported of Milken's attraction to bond investment. First of all, coupons and maturation free the astute investor much more quickly from the whims of speculation.

Second, the absence of coupons and maturation elevate the "equity duration risk" of stock investment, with no compensating return premium. This is the greatest source of systematic risk over the typical investment lifespan of individual investors, and it can't be diversified away.

If we could somehow eliminate double taxation and make it sensible for mature companies to pay dividends, it would substantially reduce the risk of equity investment, which in turn would substantially reduce and stabilize the financing costs for our entire economic system. This in turn would make it cheaper to produce, conserve, innovate, etc.

[Ray Zee]

rrom the other side of the coin. ilike stocks that pay dividends. one is that they dont have as much free money to invest. it used to be that companies were after stockholder satisfaction. now its the execs. that raid the coffers. so i dont like them having too much. they tend to invest it badly aswell. by just buying up everything and then hurting. i want the dividends even if taxed twice. i feel better with the money in my pocket.
another thing to think about. if a comany never paid out to its investors who would really want to own it. theorically you would never get a return. would you invest in a privately held company if told they would never repay you and let the company grow. that only works when you have someone to sell to that doesnt care if he gets his money back either. in publicly traded companies you should always find a buyer based on its earnings. but at some point that increased earnings gets stolen away by greedy execs. do you really think they wont raid that pile of dough for themseleves. get your profits and let the lean mean company grow by virtue of its business not from using your cash for speculation.

[Wildbill]

While there is really no simple answer, I think the majority of this question can be answered by understanding how corporate finance thinks now. They have been convinced by Wall St that instead of giving money back to shareholders by dividends, they should give it back by purchasing stock. Buybacks are thought to be better all around by Wall St because they drive up EPS. Problem that has developed is that options have diluted shares so badly, they don't really add much to EPS. Buybacks, IMO, are a neutral answer. The true problem that all of us investors need to share the blame on is that as a whole we are obsessed with earnings and EPS numbers. Wall St got us into this mess by trying to make it seem like quarterly earnings are all that matter. As this belief became pervasive, corporate finance has had to heed it to get the valuation they so desired. Buybacks are infinitely better ways to generate EPS and shareholder faith than dividends, but they are rather wasteful investments from a corporation perspective. Not that everyone prefers them, just more investors do than don't. If our mindset were to change then this would all change.

As for the argument that companies always have to pay out dividends at some point, well its not necessarily true. A company could eventually just pay back all its assets after paying off its liabilities and close shop. Obviously that is never in the interests of anyone involved because of the goodwill and intelligence a company has is worth something more than just the cash that is left over. Another way is to do a buyout, take the company private. Dividends really never need to be paid.

The math of this situation is this. Tax rates are assumed to be say 35%. If a company gives out a dividend, that means they are giving away 35% on an investment. If their capital cost is 8%, a project that is 7% is not a good idea, but giving the money back to the shareholders at about 5% is even worse. The taxation problem is a real issue because corporate taxation is stupid in and of itself. Of course it is done because the money to be generated by it is great. However, the theory of it sucks. Corporations aren't people, they are simply entities and a better economic idea is to tax people and make sure that they take all their money out of the corporation. Oh well, I digress. Indeed it would be great if they repealed the double tax on dividends, but I am not counting on it.

[CEO]

Ray, I have long admired your poker theory, particulary in lowball, back to the old days in Gardena. I left professional poker and started my own business and also to become a professional investor. My business is now the largest of its type in the world.

Although it would seem that your opinion of the business world and executives seems to be validated by the news you hear and read every day, there are many, many fine executives in both the private and the public sector, who have an extremely high level of integrity for both their own money, and that of their shareholders. People like Warren Buffett, Charlie Munger, Wm. Wringley, John Bogle (founder of Vanguard), and many more. I have met these people and would trust them with anything and everything I own.

So, while the business world, just as the poker world, does have it's "bad apples", and people who expouse to know something they do not, many of the finest people I have ever met are business people, and poker people by the way. (Mr. Sklansky included).

In the end, all business decisions, and investment decision, and poker decisions, come down to people. I would never invest 1 dollar in any company where I did not absolutely trust top management. This is the often "overlooked" vital secret to sucessful, long-term, and I might add "fortune making" way in business.

</font><blockquote><font class="small">In reply to:</font><hr />
another thing to think about. if a comany never paid out to its investors who would really want to own it. theorically you would never get a return. would you invest in a privately held company if told they would never repay you and let the company grow. that only works when you have someone to sell to that doesnt care if he gets his money back either.

[/ QUOTE ]

This is how Ponzi schemes work. ... And the current double taxation system penalizes dividend-paying companies that don't want to play along with this ripoff.

[adios]

Got that right. I see it the same way Ray does as well.

[Wildbill]

It isn't entirely this way. Remember the true losers are the markets. If the execs didn't have money to spend, that is a lot worse problem than them having too much money to spend. Dividends really only work in businesses with low capital requirements and fairly cyclical proof industries. If you are a consumer products outfit with lots of business lines, that is a business that you want to get dividends from. I think execs do indeed make what appears to be bad decisions on paper, but don't forget a majority of these are just shares they use anyways. Think about JDS Uniphase, they look like the biggest morons in history for losing billions and billions of dollars, but really they didn't lose much REAL money on these deals. They traded overpriced stock for overpriced stock, to the shareholder that means nothing. Problem is accounting rules required the company to treat the overpriced purchase at that value that the market, not real world economics, deemed. Imagine if you went out and traded your 85 Ford Escort for an 85 Nissan Sentra. Now the car might really be worth 500 bucks if you sold it in the paper, but on your books the car is worth what you paid new for it if you didn't depreciate it, lets say $10,000. So your Nissan is now worth to you...yes $10,000 if you were doing it by GAAP accounting standards. Well time comes and you sell the Sentra to your neighbor for 400 bucks. In your thinking you had a $500 car and traded it for this one and now are selling it for $400, just a $100 loss. If you did an income statement, you have to say you lost $9,600 on your car trade. Why accounting tricks are neither easy to solve or easy to make go away. Also why companies didn't care so much what the stock price was, as long as the company they bought was in the same industry. Granted many deals JDS made weren't very wise, but still the stock fell for other reasons than they didn't pay out dividends.

Dividend or no dividend is not really the question. The question is whether management is intelligently reinvesting the profits from the business. Once they've earned a dollar in income, they basically have one of three things they can do with it:
1. Reinvest in the same or buy a different business
2. Repurchase stock
3. Pay a dividend

There is no right answer. Paying the dividend is only right if the shareholder ends up with more value than the result of the other two options. BRK has done very well with option 1, while WPO has done very well with option 2. Unfortunately many companies have opted for buybacks when their stocks were insanely overvalued, or have done so only to offset insane amounts of stock option grants (like DELL).

Essentially, if they are not able to reinvest competently, they should buy back shares. However, if their stock is richly valued they should simply issue a dividend.

The 90's were a dismal era where these fundamentals were largely ignored, perhaps distorted by excessive stock option grants. It is fairly obvious that if a CEO has a large number of options he is strongly motivated to avoid paying dividends. To get back to intelligent reinvestment decisions we really have to eliminate the tax penalty on dividends, and the distortions of option compensations.

Jaeger